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Topic 12: the Balance of Payments Introduction We Now Begin Working Toward Understanding How Economies Are Linked Together at the Macroeconomic Level

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Topic 12: the Balance of Payments Introduction We Now Begin Working Toward Understanding How Economies Are Linked Together at the Macroeconomic Level Topic 12: the balance of payments Introduction We now begin working toward understanding how economies are linked together at the macroeconomic level. The first task is to understand the international accounting concepts that will be essential to understanding macroeconomic aggregate data. The kinds of questions to pose: ◦ How are national expenditure and income related to international trade and financial flows? ◦ What is the current account? Why is it different from the trade deficit or surplus? Which one should we care more about? Does a trade deficit really mean something negative for welfare? ◦ What are the primary factors determining the current-account balance? ◦ How are an economy’s choices regarding savings, investment, and government expenditure related to international deficits or surpluses? ◦ What is the “balance of payments”? ◦ And how does all of this relate to changes in an economy’s net international wealth? Motivation When was the last time the United States had a surplus on the balance of trade in goods? The following chart suggests that something (or somethings) happened in the late 1990s and early 2000s to make imports grow faster than exports (except in recessions). Candidates? Trade-based stories: ◦ Big increase in offshoring of production. ◦ China entered WTO. ◦ Increases in foreign unfair trade practices? Macro/savings-based stories: ◦ US consumption rose fast (and savings fell) relative to GDP. ◦ US began running larger government budget deficits. ◦ Massive net foreign purchases of US assets (net capital inflows). ◦ Maybe it’s cyclical (note how US deficit falls during recessions – why?). US trade balance in goods, 1960-2016 ($ bllions). Note: 2017 = -$796 b and 2018 projected = -$877 b Closed-economy macro basics Before thinking about how a country fits into the world, recall the basic concepts in a country that does not trade goods or assets (so again it is in “autarky” but we call it a closed economy). Three fundamental concepts: expenditure, output, and income. Gross national expenditure (GNE) is the total spending made by all members of the economy. ◦ What can you spend it on? consumption, investment, and government expenditures. ◦ So GNE = C + I + G. Gross domestic product (GDP) is the total value of all final goods and services produced in an economy. (The concept is limited to “final” g & s because if we included all transactions in intermediate inputs we would vastly overstate actual production. Example: if a car (final good) sells for $30,000 but includes glass steel, leather, etc. worth $20,000 we can’t count all $50,000 in GDP because that would count the intermediate inputs twice – once by themselves and once included in the costs of producing the car. So GDP is really our measure of all value added produced in the economy.) Gross national income (GNI) is total income earned by residents of a country Wages, capital income, land payments. In a closed economy these concepts all equal each other: GNE = GDP = GNI. You may recall this idea as the “circular flow” of income: output generates income, which is what’s available for spending. BOP accounts: definitions Let’s try to get these same concepts in an open economy. To do that requires understanding the BOP. The balance of payments (BOP) account is a statistical record of the flow of payments between residents of one country and the rest of the world in a given time period. Note carefully that is a statement about flows (new transactions), not stocks (cumulative past transactions). What are these payments (and receipts) for? International trade in goods and services, along with various income flows across borders, plus trade in assets. Let’s define some important parts of the BOP. ◦ The merchandise trade balance is exports of goods minus imports of goods. (Data below) This is what is commonly referred to as “the trade balance” and it has a lot of influence in political terms. ◦ But the better concept of “the trade balance” is the trade balance in merchandise and services. This is exports of goods and services minus imports of goods and services. There is no obvious reason to distinguish between goods versus services in understanding international trade. We will come back to this. Thus, the trade balance (TB) = X – IM (where X and IM include both goods and services). Question: what kinds of “services” are traded? How? BOP accounts: definitions The current account (CA) includes all transactions made in buying and selling goods and services, plus income payments and receipts. It is the trade balance in merchandise and services plus “net factor payments” plus “net unilateral transfers”. Net factor payments (NFP) is income (receipts) earned by home residents working abroad or owning capital and land abroad, minus income paid out to foreigners working here or owning capital and land here. Top examples: profits earned on capital owned abroad and wages earned by workers abroad. Net unilateral transfers refer to income received from gifts paid to home residents minus gifts sent to foreign residents. Top examples: labor remittances, foreign aid and other gifts. Putting this together the current account is supposed to measure net international transactions in “current” items, which means income received from abroad minus payments made to foreigners (not assets and liabilities). The CAB is the sum of these categories: CAB = (X – IM) + NFI + NUT. The current account: US data The following table shows CA data for the United States. Consider 2016: Exports of goods = $1.456 b; imports of goods = $2.208 => Trade balance = 1.456 – 2.208 = -$752 billion (trade deficit in goods). Exports of services = $752 b; imports of services = $505 b => balance on services = +$247 b. Trade balance (g & s) = -752 b + 247 b = -$505 billion. (The best measure of trade deficit.) Receipts of factor income (primary receipts) from abroad = $814 b. Mostly from capital. Payments of factor income (primary) to foreigners = $641 b. NFP = 814 – 641 = +$173 billion. Receipts of transfers (secondary receipts) from abroad = $135 b. Payments of transfers (secondary) to foreigners = $255 b. NUT = 135 – 255 = -$120 billion. CAB = -$505 + $173 - $120 = -$452 billion. (line 30) Relation to macroeconomic aggregates Recall in the closed economy: GNE = GDP = GNI. Things are different in the open economy. GNE is the same concept: GNE = C + I + G GDP measures output made in the domestic economy by everyone there, whether home residents or foreign labor and capital in the economy. To go from GNE to GDP: ◦ We would add exports X because that is output made domestically (but not in home expenditure). ◦ We would subtract imports IM because we need to take out of expenditures the amounts spent on imports. ◦ That is, C, I and G all have components spent on home g & s (part of GDP) and on imported goods (not part of GDP). ◦ So GDP = GNE + (X – IM), or GDP = C + I + G + (X – IM). ◦ THIS IS AN ACCOUNTING IDENTITY, TRUE BY DEFINITION. IT DOES NOT MEAN THAT IF YOU REDUCE IMPORTS YOU WILL RAISE GDP. Relation to macroeconomic aggregates We still need to get to an income measure. But both NFP and NUT add to domestic income if they are positive (and reduce domestic income if they are negative). So we have GNI = GDP + NFP + NUT. An economy’s total income is its total output (GDP) plus net inward flows of factor income and transfers. Note this means GNI > GDP for countries with positive NFP and/or NUT. Consider the following table (2015 data): why do you suppose Luxembourg and Ireland have GDP per capita that is so much higher than GNI per capita? Why the opposite for El Salvador and Philippines? Country Ireland Luxembourg Germany US El Salvador Philippines GDP pc $ 62,140 $ 101,447 $ 41,324 $ 56,469 $2,900 $3,027 GNI pc $ 51,290 $ 73,530 $ 45,790 $ 56,250 $3,880 $3,520 Back to macroeconomic aggregates The textbook combines NFP + NUT into just NFP (assuming NUT is small). So rewriting: GNI = GDP + NFP But GDP = C + I + G + (X – IM) Then GNI = C + I + G + (X – IM) + NFP The first 3 terms on the right are GNE (expenditures). Last 2 terms are the CAB. So, and this is fundamental: ****GNI = GNE + CAB**** In words: if the economy earns more income (GNI) than it spends (GNE) then it has a current- account surplus (CAB > 0). If the economy earns less income than it spends then it has a current- account deficit (CAB < 0). Again, this is an accounting identity. There is no argument about it. Saving, Investment and the CA To see this in another way, let Y = GNI (the usual textbook notation). Then Y = C + I + G + CAB If CAB > 0 => Y > C + I + G. If CAB < 0 => Y < C + I + G. Now let’s relate all this to saving and investment in the economy. Define national saving as S = Y – C – G. (Ignore taxes for now.) Then we have S – I = Y – C – G – I = CAB. Again, this is fundamental: ****S – I = CAB**** In words, a country with more domestic saving than domestic investment has a CA surplus. A country with less domestic saving than domestic investment has a CA deficit. Aside: what is investment? It is expenditures on new physical plant and equipment, inventories, structures, and land improvements within a year. Includes business expenditures but also household expenditures on new residential construction. It probably should include government investments (roads, etc.) but generally does not by convention. How do taxes enter? We think of disposable income as GNI minus taxes. So private saving is disposable income that households do not spend on consumption: SP = Y – T – C But taxes are just a transfer from households to government so we can think of T as income for the government.
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